With the general stock markets
now due for a selloff while gold hits new nominal all-time highs,
precious-metals-stock traders face something of a quandary. How are their
stocks likely to perform in the near future? Will they ignore general-stock
weakness to rally with gold? Will they get sucked into a stock-market selloff
even if gold remains strong?

There is no doubt that gold is
the primary driver of gold stocksí fortunes. Higher gold prices lead to higher
profits for this industry, and higher profits ultimately drive higher stock
prices. Over the course of this sectorís magnificent secular bull in the past
decade, this core fundamental relationship has proven itself in spades. But
just because gold is gold stocksí dominant driver doesnít mean it is their only
one.

For the great majority of
investors and speculators, most of their buying and selling decisions are an
extension of how they happen to feel at a particular time. When they are greedy
after a powerful upleg, they want to buy. When they are scared after a major
correction, they want to sell. These compelling emotions drown out true
fundamentals like the gold price and individual-company earnings results.

With greed and fear driving
most individual trade decisions, what drives collective greed and fear? The
state of the general stock markets, which is best represented by the level of
the flagship S&P 500 stock index (SPX). Traders everywhere feel very
differently about all stocks (and indeed markets) after a long SPX upleg than
they do after a serious SPX correction. They are eager to buy in the former
scenario, and eager to sell in the latter.

The more years I spend
studying the financial markets and speculating, the more awestruck I become by
the overwhelming power and ubiquity of the SPXís influence on sentiment. Big
SPX uplegs and corrections usually have a near-universal impact. They affect
every-single stock sector, other stock markets around the world, currencies,
commodities, bonds, and even national economic outlooks. Every trader looks to
the state of the stock markets for trading cues, even if they are not trading
stocks!

An extreme case in point was
late 2008ís once-in-a-century stock panic. Solely because the stock markets
plummeted, the US dollar
skyrocketed while the euro
plunged, commodities
including gold entered a free-fall, Treasury bonds soared while their yields
cratered, and the great majority of investors assumed we were on the verge of a
new great depression! A stock-market event altered perceptions
universally.

Gold (and silver) stocks are
certainly not immune to the sentiment bleedover from stock-market events. You
can argue that they should be fundamentally. Who cares what the stock markets
are doing if gold-miner profits are purely a product of prevailing gold prices?
Iíve sure wished this was the case many times in the past decade. But as
traders, we have to trade based on how the markets actually behave, not how we
want them to act.

If you carefully study the
interaction between the general stock markets, gold prices, and gold-stock
levels over this sectorís decade-long secular bull, a couple things quickly
become apparent. First, exactly as traders expect gold is the primary driver of
gold-stock prices over the long term. Second, despite this core fundamental
relationship gold stocks still decouple from gold to spiral lower with the stock
markets when they suffer material selloffs.

The broad swath of
psychological splash damage spread by general-stock fear overwhelms tradersí
rationality. So they sell precious-metals stocks regardless of what gold
happens to be doing if the stock markets are falling fast enough to generate
some real fear. While this relationship extends far back into the past, the
scope of this essay is limited to the past couple years to make this analysis
easier to digest.

This chart superimposes the
benchmark HUI gold-stock index (blue) over the SPX (red). Since we are
considering the impact of material general-stock selloffs on the HUI, these
events are highlighted in red. So far in the SPXís post-panic
cyclical bull, there have
been seven material selloffs.
Six have been pullbacks, selloffs of less than 10%. And one was a full-blown
correction, a selloff greater than 10%.

Each SPX selloff is numbered,
with the red percentage representing the headline stock-market losses. The blue
and yellow percentages show what the HUI and gold did over the exact spans of
these SPX pullbacks and corrections. While gold is certainly gold stocksí
primary driver most of
the time, during stock-market selloffs big enough to spark some universal fear
the HUI latches on to the SPX instead.

The first post-panic SPX
pullback began in June 2009. Realize this was not long after the panic lows so
the background anxiety level was still very high. The SPX slid 7.1% across a
span of just under 4 weeks. As is usually the case during stock-market
selloffs, gold was much more resilient than the SPX with a loss of just 2.8%
during this pullback. So what did the HUI do, follow gold or the SPX?

A general rule of thumb for
HUI responsiveness to gold is 2-to-1 leverage. If gold rallies 10%, gold stocks
as a group ought to rally 20% to compensate investors and speculators for their
vastly-higher riskiness. If gold falls 5%, the HUI ought to fall about 10%.
While HUI leverage to gold
can vary radically, traders generally expect the stocksí performance to at
least double the metalsí to make them worthwhile.

So with gold only down 2.8%
during that initial SPX correction, based on it alone it would be reasonable to
expect a 6%ish selloff in the HUI. But the actual came in at 10.2%,
considerably worse than the SPXís loss and 3.6x downside leverage to gold! And
note above that the HUIís pair of sharp selloffs during this SPX pullback span
corresponded exactly with the SPXís own sharp selloffs. This
relationship holds true through most of the other SPX selloffs as well.

The leading gold-stock index
not only fared worse than general stocks, but vastly worse than gold! Why?
Gold and silver stocks are risky. When the stock markets are falling,
their bearish sentiment bleeds into everything else. Tradersí appetites for
volatile assets wanes and their desire to hold cash grows more compelling. So
they sell all risky trades (including all commodities stocks) when the SPX is
weak.

The SPXís second pullback was
born in September 2009, a milder 4.3% over less than 2 weeks. Gold weathered
this weakness like a champ, down just 1.2%. So did the HUI only fall 2.4% to
reflect goldís price action? Nope. It plunged 7.7%, far exceeding both the SPX
and gold declines. This downside leverage was actually a pretty-scary 6.3x
gold! SPX selloffs scare the dickens out of PM-stock traders.

The SPXís third pullback
erupted the following month, October 2009. During its 5.6% retreat in just
under 2 weeks, gold only fell 1.7%. Yet the HUI plunged a ridiculous 12.9% over
this short timeframe! And as you can see above, its sharp selloff perfectly
mirrored the SPXís. Instead of doubling goldís decline as it ought to, the fear
splash damage from this stock-market event led to the HUI leveraging goldís
downside by a massive 7.8x! See the pattern emerging here?

The SPXís fourth pullback
starting in January 2010 was exceptional. It was the stock marketsí biggest
pullback (less than 10%) so far in this cyclical bull. Look at what was going
on in the HUI before that. The HUI had rallied rapidly to new post-panic highs
in December, but plunged sharply (as usual) when gold entered a healthy yet
steep correction. Before the SPX launched its own selloff, gold and the
HUI had already bounced and started rallying again.

This should ring a bell,
because it is exactly what is happening today. Gold and the HUI topped
in early December 2010, consolidated a month, and then entered their own
corrections in January. Then gold bounced in late January the first day the
Middle East riots really started scaring the stock markets. Naturally its
miners followed it higher. Today the vast majority of PM-stock traders are
arguing the SPX action is irrelevant because the HUI is going to follow gold,
and geopolitics will drive gold higher.

Last year I bought into a
similar argument. I knew well that the overbought levitating SPX was overdue
for a major selloff. Yet since the HUI had already corrected sharply, I
figured that its downside risk would be minimal when the SPX sold off. I wasnít
expecting gold and silver stocks to rally through an SPX selloff, but I figured
they would hold their own so we might as well start adding PM-stock positions at
that seasonally-favorable
time (early January). Boy was that a mistake!

The moment the overdue SPX
selloff finally started in mid-January 2010, the already-weak HUI plunged in
perfect parallel with the SPX. The fact that weak hands already should have
been wrung out of the gold stocks didnít matter a bit. By the time this
necessary SPX retreat ran its course to rebalance sentiment, it had fallen 8.1%
in less than 3 weeks. Meanwhile gold didnít weather that sentiment storm well,
plunging 6.6% over this short span. And the HUI, despite having just corrected,
lost another 15.4%!

One of the keys to successful
trading is learning how the markets react in certain scenarios so you can trade
accordingly in the future. And last January the hard (and crystal-clear) lesson
was that PM-stock traders as a group could not withstand the sentiment splash
damage unleashed by a material stock-market selloff. They rushed for the exits
then and I suspect they will do the same thing in this upcoming SPX correction
today.

The SPXís fifth selloff of
this cyclical bull emerging in April 2010 was its only full-blown correction
(greater than 10%). Over an exceptionally-long span approaching 10 weeks, the
SPX gave back 16.0%. Yet gold was very strong within this particular SPX
correction, surging 4.8% and achieving almost a half-dozen new all-time-record
nominal highs in the process. Surely with gold up so big, the PM stocks could
ignore the SPX weakness right? Kind of.

Instead of rallying almost 10%
to double goldís big gains, the HUI merely crept 2.7% higher over this
SPX-correction span. Sure, the PM-stock gains were a heck of a lot better than
the SPXís losses in this particular scenario. But their upside leverage to gold
was a pathetic 0.6x! Since gold stocks bear all kinds of mining-specific risks
that donít affect gold, itís unacceptable when they underperform it. Obviously
PM-stock traders were torn between following the strong gold rally and the weak
stock markets.

Consider another perspective
on this mid-2010 SPX correction. Fully 6/7ths of this eventís total losses in
the SPX occurred by early June, as the secondary early-July low was a
short-lived anomaly driven by a China scare. Up to the original June bottom of
that SPX selloff, it had lost 13.7% in 6 weeks. Meanwhile gold had surged 7.4%
higher, hitting a new all-time closing high of $1242 the very day the SPX
bottomed. Yet how did the HUI do? Only up 3.6%, less than 0.5x leverage to
goldís big run!

The SPXís sixth material
selloff of this cyclical bull started last August, a 7.1% pullback over less
than 3 weeks. Gold was actually strong over this span too, heading into its
usual big surge of Asian seasonal buying. It rallied 3.0%. Yet the HUI, even
heading into one of its strongest times of the year while gold was bumping along
over $1200 near all-time highs, only rallied 4.2%. 1.4x leverage to gold is
very poor, evidence that the HUI was again vacillating between following the SPX
or following gold.

The SPXís final and mildest
pullback of this bull so far emerged in November, when it lost just 3.9% in a
little over a week. Gold was pretty weak during this span, falling 3.7%.
Despite this, the HUI only lost 3.7% as well. This was definitely an impressive
show of strength given the weak stock markets and gold prices. But realize such
a shallow and short pullback didnít have enough time to spark any real fear in
the stock markets. And without that necessary fear infecting PM-stock traders,
they held strong.

So far weíve seen seven
material SPX selloffs in this cyclical bull in which to examine HUI
performance. In the first four, the HUI plunged farther than the SPX and far
more than gold. Gold and silver stocks were exceptionally weak, hammered very
hard by bearish general-stock psychology. And this held true whether the PM
stocks were near post-panic highs or even if they had already corrected!

In the next two selloffs, the
HUI managed to defy the SPX and climb due to strong gold rallies running
concurrent with the SPX selling. But despite goldís big gains and new record
highs, these HUI rallies were very weak. Their leverage to gold was pathetic as
PM-stock traders were torn between selling their positions in line with the SPX
selloff or buying more to try to ride the gold rally. And in that final and
shallowest SPX selloff, even though the HUI didnít leverage goldís downside it
was still pretty weak.

Every material selling event
in this cyclical bull, every general-stock pullback and correction, has affected
gold-and-silver-stock performance adversely. The HUIís downside leverage
to gold during these selloffs has run as high as 7.8x, a scary number. Would
you be happy losing 8% in your gold stocks for every 1% gold fell? And the
very-best performance of the HUI during an SPX selloff when gold was very strong
was unacceptable 1.4x upside leverage. This isnít enough to compensate traders
for PM stocksí big risks.

In light of this precedent,
which extends back many years beyond the couple Iíve highlighted here, why take
the risk of owning short-term PM-stock speculations if the probabilities favor
an imminent general-stock selloff? For a variety of technical and sentimental
reasons, a major SPX
correction looms today. It may have already started! As a speculator I
want high-probability-for-success trades, and the evidence is crystal-clear that
no matter what gold does the PM stocks donít fare very well during SPX
selloffs.

At Zeal we are trading
accordingly. Weíve realized the great majority of our massive gains from this
huge SPX upleg since September. Weíre mostly in cash, the best way to weather a
major SPX selling episode which will hammer down all commodities stocks like
usual. And then when the dust settles as the SPX selloff matures, weíll be
ready to buy the resulting magnificent bargains. Why rush to buy high when a
little patience ought to yield high odds of being able to buy low?

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The bottom line is
precious-metals stocks follow the general stock markets during material
selloffs. Even though gold is their primary driver most of the time, they
decouple from this metal and glom on to the stock markets during pullbacks and
corrections. If both the stock markets and gold are weak, the PM stocks plunge
far more than either. And even if gold is strong, PM stocks are torn and
seriously underperform.

The bearish psychology sparked by stock-market selloffs is so
powerful that it permeates all markets, including PM stocks. Iím not thrilled
with this correlation, but it is well-established hard reality. PM-stock
traders have proven over and over again that they canít ignore a stock-market
selloff even when gold is strong. So traders really need to be wary of gold
stocks when the stock markets face an imminent selloff.